Strategic default

Last updated

A strategic default is the decision by a borrower to stop making payments (i.e., to default) on a debt, despite having the financial ability to make the payments.

Contents

This is particularly associated with residential and commercial mortgages, in which case it usually occurs after a substantial drop in the house's price such that the debt owed is (considerably) greater than the value of the property — the property has negative equity or is underwater — and is expected to remain so for the foreseeable future, such as following the bursting of a real estate bubble. Such borrowers are called walkaways. [1] The process of strategically defaulting on a home mortgage has been colloquially called "jingle mail" — metaphorically, one mails the keys to the bank.

Prevalence post-housing bubble

Economists Paul Krugman and Hal Varian argued that strategic default would be an inevitable result of the collapse of the finance and property bubble of the era following 2006. They also noted that this is one of the few ways of freeing people from the burden of mortgage debt. Once free of the mortgage, debtors are free to use their income for other expenditures. [2]

A study in September 2009 from the credit reporting agency Experian and consulting outfit Oliver Wyman estimated that close to a fifth of troubled mortgages in the U.S. involved borrowers who were strategically defaulting. [3]

Effects

Effects vary by jurisdiction; different countries and different states in the United States treat default on mortgage debt differently, notably distinguishing whether it is recourse debt and non-recourse debt, meaning whether the mortgage lender can pursue claims against the defaulted debtor. Further, mortgage refinancing may be treated differently from an original, un-refinanced mortgage, and mortgages on second homes may be treated differently from mortgages on primary residences.

The borrower after deciding to not make payments any more can live free of the costs of payment or rent until the lender forecloses, which may take from several months to years. A borrower may use this time to extinguish or negotiate other debt. Mortgage lenders may negotiate with defaulting borrowers to assure maintenance and occupancy of the property until the lender can take title and market the house, and may provide the defaulting borrower with greater than the minimum legal notice to quit (which can be as little as three days) and may even agree to pay a fee to leave the home in pristine condition.

Foreclosure of the borrower's house will result in a negative entry on the borrower's credit rating, possibly making obtaining loans in the future more difficult or more expensive for the borrower. With otherwise good credit a new mortgage from US government agencies will be denied until 3 (FHA) to 7 years (FNMA) have passed since the actual date of foreclosure.

The difference between the value of the property at the time of foreclosure and the amount of the note (assuming the note is larger) is considered by the IRS as "debt forgiven" and may be considered "income" subject to federal income tax. For a short period ending at the end of December 2012 due to the Mortgage Forgiveness Debt Relief Act of 2007, this "phantom income" was not subject to tax on primary residences.

Ethical issues

Some ethicists have questioned the morality of strategic default, arguing that one has a duty to make payments on debt if one is able. [4] Others argue that there is no such moral duty, a loan being a contract between consenting adults, and noting that financial investors routinely default on non-recourse loans that have negative equity. [3] Some argue further that there is a moral duty to strategically default, [4] and that one should make such decisions based on one's financial interest "unclouded by unnecessary guilt or shame", as lenders who do not modify mortgages do the same, "seek[ing] to maximize profits or minimize losses irrespective of concerns of morality or social responsibility," [5] or more bluntly stating that "The economy is fundamentally amoral." [6] Further, obligations to honor a contract are balanced by obligations to oneself and one's family, the latter speaking in favor of strategic default, some arguing "You need to put yourself and your family's finances first," [6] while one also has obligations to a community, which may be damaged by default. [4]

Other jurisdictions

In Europe, there are generally no pure nonrecourse debts for private persons. Therefore, they need to pay remaining debts even if leaving their houses. Because having a home to sleep in is prioritized, the house mortgage is usually prioritized, while other debts might be abandoned if they cannot be paid.

Strategic bankruptcy of companies is however common in Europe.

See also

Related Research Articles

<span class="mw-page-title-main">Default (finance)</span> Financial failure to meet legal conditions of a loan

In finance, default is failure to meet the legal obligations of a loan, for example when a home buyer fails to make a mortgage payment, or when a corporation or government fails to pay a bond which has reached maturity. A national or sovereign default is the failure or refusal of a government to repay its national debt.

<span class="mw-page-title-main">Debt</span> Obligation to pay borrowed money

Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.

<span class="mw-page-title-main">Loan</span> Lending of money

In finance, a loan is the transfer of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay interest for the use of the money.

A mortgage is a legal instrument of the common law which is used to create a security interest in real property held by a lender as a security for a debt, usually a mortgage loan. Hypothec is the corresponding term in civil law jurisdictions, albeit with a wider sense, as it also covers non-possessory lien.

<span class="mw-page-title-main">Foreclosure</span> Legal process where a lender recoups an unpaid loan by forcing the borrower to sell the collateral

Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments to the lender by forcing the sale of the asset used as the collateral for the loan.

A reverse mortgage is a mortgage loan, usually secured by a residential property, that enables the borrower to access the unencumbered value of the property. The loans are typically promoted to older homeowners and typically do not require monthly mortgage payments. Borrowers are still responsible for property taxes or homeowner's insurance. Reverse mortgages allow older people to immediately access the home equity they have built up in their homes, and defer payment of the loan until they die, sell, or move out of the home. Because there are no required mortgage payments on a reverse mortgage, the interest is added to the loan balance each month. The rising loan balance can eventually grow to exceed the value of the home, particularly in times of declining home values or if the borrower continues to live in the home for many years. However, the borrower is generally not required to repay any additional loan balance in excess of the value of the home.

Predatory lending refers to unethical practices conducted by lending organizations during a loan origination process that are unfair, deceptive, or fraudulent. While there are no internationally agreed legal definitions for predatory lending, a 2006 audit report from the office of inspector general of the US Federal Deposit Insurance Corporation (FDIC) broadly defines predatory lending as "imposing unfair and abusive loan terms on borrowers", though "unfair" and "abusive" were not specifically defined. Though there are laws against some of the specific practices commonly identified as predatory, various federal agencies use the phrase as a catch-all term for many specific illegal activities in the loan industry. Predatory lending should not be confused with predatory mortgage servicing which is mortgage practices described by critics as unfair, deceptive, or fraudulent practices during the loan or mortgage servicing process, post loan origination.

<span class="mw-page-title-main">Household debt</span> Combined debt of all people in a household

Household debt is the combined debt of all people in a household, including consumer debt and mortgage loans. A significant rise in the level of this debt coincides historically with many severe economic crises and was a cause of the U.S. and subsequent European economic crises of 2007–2012. Several economists have argued that lowering this debt is essential to economic recovery in the U.S. and selected Eurozone countries.

Repossession, colloquially repo, is a "self-help" type of action, mainly in the United States, in which the party having right of ownership of the property in question takes the property back from the party having right of possession without invoking court proceedings. The property may then be sold by either the financial institution or third party sellers.

Nonrecourse debt or a nonrecourse loan is a secured loan (debt) that is secured by a pledge of a collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender can seize and sell the collateral, but if the collateral sells for less than the debt, the lender cannot seek that deficiency balance from the borrower — its recovery is limited only to the value of the collateral. Thus, nonrecourse debt is typically limited to 50% or 60% loan-to-value ratios, so that the property itself provides "overcollateralization" of the loan.

<span class="mw-page-title-main">Security interest</span> Legal right between a debtor and creditor over the debtors property (collateral)

In finance, a security interest is a legal right granted by a debtor to a creditor over the debtor's property which enables the creditor to have recourse to the property if the debtor defaults in making payment or otherwise performing the secured obligations. One of the most common examples of a security interest is a mortgage: a person borrows money from the bank to buy a house, and they grant a mortgage over the house so that if they default in repaying the loan, the bank can sell the house and apply the proceeds to the outstanding loan.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, and if the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower. An example is the foreclosure of a home. From the creditor's perspective, that is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

<span class="mw-page-title-main">Mortgage loan</span> Loan secured using real estate

A mortgage loan or simply mortgage, in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crisis. The crisis led to a severe economic recession, with millions of people losing their jobs and many businesses going bankrupt. The U.S. government intervened with a series of measures to stabilize the financial system, including the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA).

Mortgage underwriting is the process a lender uses to determine if the risk of offering a mortgage loan to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C's of underwriting: credit, capacity and collateral.

The Mortgage Forgiveness Debt Relief Act of 2007 was introduced in the United States Congress on September 25, 2007, and signed into law by President George W. Bush on December 20, 2007. This act offers relief to homeowners who would have owed taxes on forgiven mortgage debt after facing foreclosure. The act extends such relief for three years, applying to debts discharged in calendar years 2007 through 2009. With the Emergency Economic Stabilization Act of 2008, this tax relief was extended another three years, covering debts discharged through calendar year 2012. The relief was further extended until January 1, 2014, at Section 202 of the American Taxpayer Relief Act of 2012.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

Loan modification is the systematic alteration of mortgage loan agreements that help those having problems making the payments by reducing interest rates, monthly payments or principal balances. Lending institutions could make one or more of these changes to relieve financial pressure on borrowers to prevent the condition of foreclosure. Loan modifications have been practiced in the United States since the 1930s. During the Great Depression, loan modification programs took place at the state level in an effort to reduce levels of loan foreclosures.

<span class="mw-page-title-main">Mortgage industry of the United States</span>

The mortgage industry of the United States is a major financial sector. The federal government created several programs, or government sponsored entities, to foster mortgage lending, construction and encourage home ownership. These programs include the Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.

A bank walkaway is a decision by a mortgage lender to not foreclose on a defaulted mortgage, or to not complete foreclosure proceedings. These are sometimes referred to as abandoned foreclosures or stalled foreclosures, though this latter term is also used more broadly when the foreclosure process has stalled for other reasons.

References

  1. "Credit: Beware of the Walkaways". Time. 1962-07-27. Archived from the original on May 13, 2010. Retrieved 2010-05-24.
  2. Krugman, Paul (2008-02-12). "One to the Left". New York Times. Retrieved 2010-05-24.
  3. 1 2 Gimein, Mark (2009-10-08). "Go Ahead, Walk Away: There is nothing immoral about ditching your mortgage". The Big Money.
  4. 1 2 3 Hagerty, James R. (2009-12-17), "Is Walking Away From Your Mortgage Immoral?", The Wall Street Journal , archived from the original on 2010-01-28
  5. White, Brent (2009-12-07), Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis, doi:10.2139/ssrn.1494467, S2CID   154925963, SSRN   1494467
  6. 1 2 Arends, Brett (February 26, 2010), When It's OK to Walk Away From Your Home, The Wall Street Journal